Clear Eyed Capitalist

Archive for November, 2017

I’ve had the privilege of sitting in on a healthcare innovation class put together by the fabulous Emer Dooley for the University of Washington. The learnings from that class are a whole blog by itself. In talking about healthcare, a quick reference to its significance as an expense is that it’s the 2nd largest single expanse a company has, after payroll. The unpredictability & volatility of it as an expense for self-insured companies is a significant stress point for companies not used to being in the insurance business (The AOL “distressed baby” mishap being an extreme example) but the overall expense is so high that companies as small as 3,000 employees are going self-insured. Net, that means they keep the premiums, they take the risk on the expenses, and they pay an insurance company a small % to handle the administration & billing.

Now to that “single” biggest expense of payroll –if you look at a public financial statement it’s usually there as a lump sum. This is a great example of how financial statements are written for and by accountants. Payroll for small companies is often outsourced to a third party to make sure all the appropriate tax withholdings are done and passed on to the appropriate authorities at the right time. Larger companies may bring that back in as a department. For the company itself, it’s a big expense that happens on a single day, 2-3 times a month. Reconciliation of it is complex because employees can have all kinds of individual variations with deductions, vacations or leaves, new and departing employees. For the accounting department, payroll is a BIG deal. For managing cashflow, payroll is a BIG deal. It needs to be attended to as a thing.

But what a skilled executive/manager should know, is that payroll is not actually a thing in itself. If you’re looking at your expenses, it’s not helpful to look at “payroll”. It represents an agglomeration of many functions of a company – product creation, product validation, sales, distribution, marketing, customer relations. When you’re thinking about how your resources are currently allocated and might be better allocated, you want to think about those categories, and the people/energy going into them, and the effectiveness of those against expectations for their category. If you’re looking to invest more or make cuts, good management needs to focus on those areas of company function, not just on “payroll”.

This is reinforced for me as I listen to Zeynep Ton’s The Good Jobs Strategy. She talks about her work with retail chains facing falling sales and deciding to cut payroll, without doing the analysis to discover that the falling sales were due to poor customer service. Instead of improving profitability, they got into a vicious circle that resulted in store closings. She worked with Borders for 5 years and was able to show that in many cases, increasing payroll actually increased sales. The key there is, again, that payroll is not a thing – it’s a construct made for the accounting department to manage cashflow. What they were really tinkering with was customer service.

If you run one of the many small (and not so small) businesses managing on Quickbooks, congratulations to you if you’ve developed a habit of looking at your P&L on a monthly basis and comparing it to budget and re-projecting your cashflow. Most likely, you have a line item that’s “payroll”, or “wages”. You can start by at least breaking it into sub-categories: marketing, sales, production (hopefully you are already breaking out your direct labor so you can correctly calculate fixed costs vs variable costs), administration, distribution. Things like IT and professional services- if outsourced- will show up somewhere else. Then go ahead and let all the payroll taxes sit as a lump sum because they’re not really discretionary anyway. The key here is to look at your relative investment in the various functions of your business.

If you really want to look at your overall expenses that way, go ahead and move those payroll categories into the various sections of your P&L. Keep them as distinct line items so you can add them back together when you or your bookkeeper are doing bank reconciliation against that transfer to the payroll company. You can leave payroll taxes as a line item under administration or general – they’re less discretionary, they just vary with your payroll. For finer grain detail on the total cost of in-house vs outsourcing you’ll need to consider the payroll taxes. Then a quick glance down your P&L will help you see where the resources of your company go at a high level. Are you investing enough in marketing? Whether it’s outsourced or in-house, whether it’s labor or google ads, how much is it as a % of sales? Are you spending a significant amount on production or service? If that’s the business you’re in, I hope so. If it’s not translating into sales, you can start asking why.